Stock Trading, Information Production and Incentive Pay∗

This paper examines under what circumstances the market-based compensation scheme is effective in inducing managers’ incentives. We combine the optimal contract theory with the market microstructure literature and endogenize both the optimal compensation scheme and the stock market equilibrium. We analytically show that the incentive pay works better in a more efficient (or more informative) stock market. Empirical tests justify our model prediction. Using residual analyst coverage as one proxy for market informativeness, we find that the coverage is negatively related to the compensation level and positively to the pay-for-performance sensitivity, suggesting that an efficient market induces managerial incentives as well as structures their behavior. JEL Classification: D80, G14, G34, J33